Friday, April 25, 2008

The past eight months have blown apart any cosy assumptions that it is possible to draw a simple dividing line between institutions that need to be regulated and those that do not. It has become painfully clear to regulators that loosely regulated entities such as SIVs have remained so tightly entwined with their originating banks that their problems tend to migrate back to those regulated banks.

It has also become clear that these so-called “shadow banks” cannot be viewed merely as a minor appendage of the mainstream financial world. JPMorgan, for example, recently calculated that activity in so-called parallel – or unregulated – US banking was worth $5,900bn last year, compared with $9,400bn for regulated banking.

Most pernicious of all, the explosion of derivatives and other complex financial arrangements has left institutions so closely intermeshed in their market dealings that it is increasingly difficult to ring-fence regulated entities from problems emanating from less regulated institutions. Take Bear Stearns. A couple of decades ago, regulators would probably have presumed that this broker was not in the category of “too big to fail”, since it did not serve retail clients on a large scale and was not a commercial bank. The Fed last month tacitly recognised, however, that Bear was now in effect “too interconnected to fail”. That is partly because Bear was a crucial participant in the $62,200bn credit derivatives market.

Since transactions in products such as credit default swaps – derivatives used to protect against the risk of a borrower defaulting on its debt – are conducted via private bilateral deals between banks, some regulators and bankers feared that a collapse of Bear would create serious fears about “counterparty risk” – the danger that market participants would stop honouring credit default swap contracts. Thus, while those swaps did not cause the crisis, Bear’s problems highlighted potential weaknesses in this market that could have hurt numerous others.

Bear was also a central participant in the so-called tri-party repo market, the sector where banks and brokers lend securities to each other overnight in exchange for cash. This sector is crucial to banks’ funding. Contracts in this little-watched corner of finance also tend to be tightly entwined. When Bear started to face problems funding itself through repurchase transactions, Fed officials feared this would cause the broker to default on its related contracts, sparking a daisy chain of defaults across the banking sector. “It was the repo thing that really scared people – there was the potential for a huge panic,” says one senior American financial official.

Stoneleigh: Unfortunately, requiring exchanged-traded rather than OTC investment now would be locking the barn door after the horse has bolted. The shadow banking system already exists, as does the systemic risk, which is coming closer by the day to being realized.

In the two decades of Greenspan's tenure, the Fed's Washington staff, other regulators and the Congress allowed and enabled Wall Street to migrate more and more of the investment world off exchange and into the opaque world of over-the-counter derivative instruments and structured assets. This change is described by people like Greenspan and Treasury Secretary Hank Paulson as "innovation," but our old friend Martin Mayer rightly calls it "retrograde."

In a market comprised primarily of exchange traded instruments, there is little or no counterparty risk. OTC trades which reference exchange traded benchmarks are likewise far more stable. By replacing exchange traded securities with ersatz OTC instruments, Greenspan and the quant economists who dominate the Fed's Washington staff have created vast systemic risk that need not exist at all and that now threatens our entire financial system.

BSC failed not because it had too little capital or too little liquidity, but because the thousands upon thousands of OTC trades which flow through the firm's books are bilateral rather than exchange traded. It was the understandable fear of counterparty risk, not a lack of capital or liquidity, which killed BSC. The irony is that the "financial innovation" of OTC derivatives and structured assets takes us backward in time to the chaotic situation that existed in the US prior to the crash of 1929.

Would that the Congress and the Fed had the courage to confront Paulson and the other banksters who have turned America's financial markets into an increasingly unstable, derivative house of cards. If all federally insured commercial banks, mutual and pension funds were required by law to invest only in SEC registered, exchange-traded instruments, the threat of further systemic risk could be eliminated tomorrow. What a shame that neither Chairman Bernanke nor FRBNY President Timothy Geithner said that last week when they appeared before the Senate Banking Committee.

Earlier this year, we warned that America's credit woes involved much more than just a slowdown. We wrote that it was actually a credit crack-up — an outright contraction of credit the likes of which had never been witnessed in our lifetime....

....Until the third quarter of last year, U.S. commercial banks had been making consistent profits from their derivatives quarter after quarter.

Their total revenue from these and related transactions never dipped into negative territory ... rarely suffered a significant decline ... and was even making brand new highs through the first half of 2007.

Then, suddenly, in the fourth quarter of last year, we witnessed a landmark game-changing event: For the first time ever, U.S. commercial banks lost big money in derivatives in the aggregate.

Again, if this were part of a planned retreat by the banks to more prudent trading approaches, it would be a positive. But it's anything but!

Indeed, the Comptroller of the Currency specifically states in his report that the sudden and unusual reduction in derivatives was due entirely to the turmoil in the credit markets.

And ironically, nearly all of that turmoil was concentrated in “credit swaps” — the one sector that was designed to protect investors from this precise situation.

These credit swaps were supposed to act as insurance policies that big banks and others bought to help cover their risk in the event of defaults and failures. But they're not working out as planned: Just in the fourth quarter, U.S. banks had a net loss (after all profitable trades) of $11.8 billion on credit swaps alone, according to the OCC.

Those losses helped wipe out all the profits they made in other derivatives, leaving a net overall loss of $9.97 billion.

The Greenspan credit bubble and Europe’s EMU bubble (Club Med, Ireland, and ERM-fixers in Denmark and Eastern Europe) have together infused so much poison into the Atlantic economy that it will require a brutal purge - like chelating heavy metals from the brain.

America, of course, is already in recession – although the cascade of defaults, business closures, and job losses has barely begun.

Japan is in recession too, according to Goldman Sachs. It is still the world’s second biggest economy by far, lest we forget.

Britain, Ireland, Spain, Italy, and New Zealand, are tipping into housing slumps and demand implosions of varying severity.

Ontario and Quebec have stalled. Canada’s growth is the weakest in fifteen years, hence the half point cut by the Bank of Canada yesterday.

Australia is on borrowed time, whatever the price of coal and iron ore. Household debt is 175pc of disposable income, up in La La Land with England, Ireland, Denmark, and the Dutch. The wholesale funding market for mortgages that underpins this nonsense remains frozen.

Together these countries and regions make up roughly 45pc of the global economy, and over half global demand. My hunch is that this bloc will be sliding towards full-blown deflation within a year as the commodity bubble pops and job losses set off a self-feeding downward spiral.

Stoneleigh: Subprime Nation isn't really the right word, as the US debt disease is far larger than subprime. At all levels of society people have maxed out their credit and are now acutely vulnerable to the inevitable increases in long term interest rates.

During the 1970s, the U.S. banking system stood as an intermediary between oil-exporter surpluses and emerging market borrowers in Latin America and elsewhere. While much praised at the time, 1970s petro-dollar recycling ultimately led to the 1980s debt crisis, which in turn placed enormous strain on money center banks.

It is true that this time, a large volume of petro-dollars are again flowing into the United States, but many emerging markets have been running current account surpluses, lending rather than borrowing. Instead, a large chunk of money has effectively been recycled to a developing economy that exists within the United States’ own borders. Over a trillion dollars was channeled into the sub-prime mortgage market, which is comprised of the poorest and least credit worth borrowers within the United States. The final claimant is different, but in many ways, the mechanism is the same.

Simply put: U.S. banks found a Third World nation of borrowers willing to shoulder high interest rates within the U.S. itself: let's call it Subprime Nation. Here are three snapshots of Subprime/Alt-A/No-Doc/Option ARM Nation:

1. Subprime Nation has little or no ownership of assets2. Subprime Nation's mortgage resets will continue to climb through 20113. Subprime Nation has borrowed itself into a deep, deep hole

Seven out of 10 troubled mortgage borrowers remain without a plan to work out their loans despite increased industry efforts to help them, according to a new report from a coalition of state attorneys general and banking regulators.

The group collected data from 13 of the largest subprime lenders from October through January and found that the lenders are overwhelmed by their workloads and unable to keep pace with the number of borrowers who are falling behind on payments....

....Lenders are failing to make headway because they can't keep up with the number of delinquent loans. About 50,000 more loans were modified in January than in October, Pearce said. But 90,000 additional loans became delinquent during that time.

As much as I have little sympathy for companies that made a lot of money during the gravy days of the housing bubble and now plead poverty as an excuse for inaction, this bill [to require servicers to attempt loss mitigation before foreclosing] would send .an industry under stress to the wall. It will have to incur the costs of notification and reporting for all defaulting borrowers, but will be able to collect fees only out of continuing cash flow from the borrower or a foreclosure sale. Most of these activities (setting up a call center, creating methods, forms, and supporting systems for borrower communication and regulatory reporting) have high fixed and low variable costs. It will be hard to determine the right fee levels up front (and you can't readily go back if you got it wrong). And its quite possible the fees will look disproportionate, even if they are costed properly.

Plus there's a big cash flow problem: the costs are incurred up front, the fees recovered over time. And servicers are already having big time cash flow problems. I have been told that servicers, which in most cases are part of large banks, are hemorrhaging cash. Notes from a conversation with informed parties:

The servicer has guaranteed to pay whatever interest is promised to the investors for at least 90 days after default. Some agreements also require them to pay principal during that period. Even after the 90 days, the servicer has to continue to pay real estate taxes and insurance. The servicer can use any late payment or other penalties from the borrower to offset these costs.

The idea was that if you were good at collecting and efficient at serciving, the overcollateralization would give you enough of a cushion. But they assumed 5% loss rates, not 20%.

And the cash flow drain is worse in prime or mixed pools than in subprime pools. The defaults relative to assumptions are far worse there.

As we noted, the banks will probably dodge this bullet. But a measure like this is an indicator of how sentiment about regulation is changing, Expect to see more tough-minded proposals, some of which will stick.

Stoneleigh: I don't think these people have much of a clue how miserable things can really get, but then they only look back 25 years and that isn't nearly long enough. They do point out though, that so far the numbers aren't bad enough to indicate a bottom even for a run-of-the-mill banking crisis. As the credit crunch is clearly systemic it will actually be much worse.

Yup, that's what the good doctors at Citigroup are prescribing for the global financial sector, which despite a rebound in the past month is still down almost 30 per cent from its peaks of the middle of last year (based on the MSCI World Financials index). At their March lows, the S&P 500 financials group was down 38 per cent from last year's peak, while Toronto's S&P/TSX financials index was off 26 per cent. Quite the haircut.

You'd think the sector would have already had its fill of negative news: The subprime collapse, liquidity strains, massive writedowns, weak financial markets, slumping investment banking business, rising loan defaults. But Citigroup's global equity strategy team argues that we may not have seen the bottom for the sector yet – and it may take still more bad news to get us there.

In particular, the strategists believe that neither the economic outlook nor the level of loan defaults have yet deteriorated far enough to signal that things have gotten about as miserable as they can get. They reached this conclusion after examining conditions in previous financial crises that have hit various places around the world in the past 25 years....

....The Citigroup team says the percentage drop in share values for the sector is in line with non-systemic financial crises, and the duration of the selloff has already exceeded the average of about eight months.

However, they note that typically, the bottom for financial stocks in non-systemic crises doesn't come until the economic signals hit their bottom – and so far, the evidence suggests they aren't there yet, even in the United States. The U.S. Conference Board's Leading Economic Index, a composite of forward-looking economic indicators, has shown year-over-year declines for the past six months, but it still hasn't fallen to the depths seen in previous U.S. banking crises. The story is similar for Canada, while the euro zone leading indicator is still running above its long-term trend.

Perhaps of more significance is the historical evidence that financial stocks don't typically bottom until the rate of speculative-grade credit defaults approaches 10 per cent. And what's the rate of these credit defaults in the supposedly credit-crippled U.S. market? Less than 2 per cent.

These are anxious days for Ralph R. Cioffi, the former manager of the two Bear Stearns (BSC) hedge funds whose collapse last summer sparked the credit crisis. Federal prosecutors are expected to decide by June whether or not to bring charges against him and members of his team. Wall Street is watching closely: If the Justice Dept. can't make a case against Cioffi, a prime figure in the mortgage mess, other criminal investigations may hit a dead end as well....

....The probe is moving forward on two fronts, looking at whether the managers deliberately misled investors about the funds' health and whether Cioffi and his team conjured up fraudulent values for the funds' risky subprime securities. The latter is what matters most to other investment banks. The issue of how Wall Street priced those collateralized debt obligations, the values of which were based on internal models rather than actual values, has been controversial ever since the market for them evaporated last year. "If the valuations become a criminal issue [for] Bear Stearns, it would send a warning shot across the bow of every firm that marketed these exotic products," says Steven B. Caruso, a litigator representing several Bear investors....

....The subprime mess only muddles matters. Lawyers note it wasn't just a few funds that may have relied on faulty pricing models. Rather, the problems seem to have permeated the entire financial system, given the $250 billion in subprime-related writedowns so far. "This was a Street-wide failure," says another former federal prosecutor

It's predictable that embattled Ambac CEO Michael Callen would claim that all is well at the bond insurer in the face of considerable evidence to the contrary in the form of first quarter net loss of $1.66 billion, which wiped out last month's highly dilutive capital raise of $1.5 billion. Ambac had to triple its common shares last go-round to raise money that was now clearly inadequate to strengthen its balance sheet, as the rating agencies demanded.

Consider further: there is no new business for the monoliines. They've sworn off the securitized credit market, and with rating agencies re-doing their grading scales for municipalities, that low-risk credit arbitrage is gone.

It gets even better: Goldman predicts that Ambac and MBIA each need to raise $3.4 billion more in capital. How, pray tell, and at what cost?

Despite these rather uncomfortable facts, Callen asserts that the ratings are "solid'. Fitch doesn't think so and already downgraded Ambac to AA. Rating agency Egan Jones doesn't think so and has been a long-time critic of the bond guarantors. The credit default swaps market doesn't think so. Even New York State insurance superintendent Eric Dinallo has doubts.

And the last time I recall a company saying its liquidity was fine was Bear, and at least at the time of its crunch, Bear's long-term prospects looked better than Ambacs' do (there is still ample debate as to whether Bear was insolvent or not: the answer in most cases depends on one's view of the credit default swaps market).

A key vote on the $32-billion restructuring plan for the frozen asset-backed commercial paper market can proceed as scheduled Friday, leaving only one major hurdle before the possible end of a nine-month ordeal that began when the market froze in August.

Ontario Superior Court Justice Colin Campbell said that postponing the vote as requested by some corporate holders of the paper "would signal the failure of the plan. A failure of the plan will have extremely serious consequences." Mr. Campbell also denied the request by Barrick Gold Corp., Jean Coutu Group (PJC) Inc. and other corporate holders of the paper to let them vote as a separate class, saying that would result in a postponement of the vote.

“We are delighted by today's decision,” said Purdy Crawford, who led the investor committee that crafted the plan.

However, the judge said he will still consider other arguments by corporate holders that the restructuring proposal is unfair because it contains legal releases immunizing some players in the ABCP market to lawsuits, but that will have to wait for another hearing on the fairness of the plan after the vote.

Stoneleigh: A teenaged cashier in the grocery store told me yesterday that rice prices were going to go up. If awareness has spread that far, then I wonder how long it might be before we switch over into a hoarding mentality, thereby creating a self-fulfilling prophecy.

Several forces that have shielded Canadians from serious food inflation are losing their effectiveness.

The loonie soared 17 per cent against the U.S. dollar last year, but few experts expect it to rise much more. That means Canadians will start feeling the full impact of record high prices for commodities such as wheat, corn and soybeans, which are priced in U.S. dollars. Rising fuel costs will also pump up shipping costs.

Meat prices have been low because of a glut of livestock, particularly hogs, in Canada and the United States. But herds on both sides of the border are starting to come down in size because farmers have been losing so much money. The futures market is indicating that meat prices will rise by next fall.

Costs for farmers have also skyrocketed. The price of fertilizer has more than doubled since last fall, while diesel fuel and other chemicals have also gone way up. Meanwhile, commodity markets have gyrated wildly in recent weeks, sending the price of wheat, canola and corn soaring one day and plummeting the next. That has added more risk for farmers and left many wondering if the markets are working at all.

"It's been very disruptive," said Eric Fridfinnson, a farmer in Manitoba who has been trying to figure out how much he might get for his crops this year. "I think that there really does need to be an examination of all futures markets."

Many farmers blame the growing influence of investment funds for distorting commodity prices. According to figures compiled by Gresham Investment Management, a commodities brokerage in New York, the amount of speculative money in commodities futures - that is, investors such as big funds that don't buy or sell the physical commodity but merely bet on price movements - was less than $5-billion (U.S.) in 2000. Last year, it ballooned to roughly $175-billion.

By some estimates, investment funds control 50 per cent of the wheat traded on the Chicago Board of Trade and Chicago Mercantile Exchange, the world's biggest commodity markets.

In a glass tower on the outskirts of New Delhi, dozens of young Indians are on the telephone, calling America’s out of work, forgetful and debt-stricken and asking for cash.

“Are you sure that’s all you can afford?” one operator in a row of cubicles asks politely. “Well, how do you take care of your everyday expenses?” presses another.

Americans are used to receiving calls from India for insurance claims and credit card sales. But debt collection represents a growing business for outsourcing companies, especially as the American economy slows and its consumers struggle to pay for their purchases.

Armed with a sophisticated automated system that dials tens of thousands of Americans every hour, and puts confidential information like Social Security numbers, addresses and credit history at operators’ fingertips, this new breed of collectors is chasing down late car payments, overdue credit card debt and lapsed installment loans. Debt collectors in India often cost about one-quarter the price of their American counterparts, and are often better at the job, debt collection company executives say.

CR, that Jeff Rubins unchained is wild. Recent articles talking about testosterone. Well his levels must be high!Would love to see him and Roubini!And we're sure a long way from $100 for oil! Remember when $100 seemed like a far off, a not likely number! Doesn't look like the US is going to allow Canada an independent future does it.